Flat Rate Supplemental Wage Withholding, 767-773 [05-71]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 70, Number 3 (Wednesday, January 5, 2005)]
[Proposed Rules]
[Pages 767-773]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 05-71]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 31

[REG-152945-04]
RIN 1545-BD96


Flat Rate Supplemental Wage Withholding

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations amending the 
regulations that provide for the flat rate of withholding applicable to 
calculating the amount of income tax withholding on supplemental wages. 
The proposed amendment to the regulations reflects changes in the law 
made by the Revenue Reconciliation Act of 1993, the Economic Growth and 
Tax Relief Reconciliation Act of 2001, the Jobs and Growth Tax Relief 
Reconciliation Act of 2003, and the American Jobs Creation Act of 2004. 
Under the American Jobs Creation Act of 2004, the optional flat rate 
for withholding on supplemental wages will generally remain at 25 
percent for payments made after December 31, 2004, but may change if 
income tax rates change. However, the 2004 Act also provides that, 
after 2004, if an employee receives supplemental wages in excess of one 
million dollars from an employer in a calendar year, the excess of the 
supplemental wages over one million dollars is subject to mandatory 
income tax withholding at the highest income tax rate. The highest 
income tax rate is currently 35 percent. In determining whether an 
employer has reached the one million dollar threshold for an employee, 
supplemental wage payments from all businesses under common control and 
from agents will be taken into account.

DATES: Written or electronic comments and requests for a public hearing 
must be received by April 5, 2005.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-152945-04), room 
5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submission may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
152945-04), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC or sent electronically, via the IRS 
Internet site at https://www.irs.gov/regs or via the Federal eRulemaking 
Portal at https://www.regulations.gov (IRS and REG-152945-04).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
A. G. Kelley, (202) 622-6040; concerning submission of comments, Treena 
Garrett, (202) 622-3401 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    The Employment Tax Regulations distinguish between regular wages 
paid for a payroll period and supplemental wages for purposes of income 
tax withholding. Although the regulations do not give a comprehensive 
definition of the term ``supplemental wages,'' the regulations provide 
that supplemental wages include ``* * * bonuses, commissions, and 
overtime pay, paid for the same or a different period, or without 
regard to a particular period.'' Regulations and revenue rulings have 
provided other examples. See Sec.  31.3401(a)-1(b)(8)(i)(b)(2) of the 
regulations (sick pay paid by an agent of the employer); Sec.  
31.3401(a)-4(c) of the regulations (wages paid under reimbursement and 
other expense allowance arrangements); Rev. Rul. 67-257)1967-2 C.B. 
359) (income recognized on exercise of nonqualified stock option); Rev. 
Rul. 67-131 (1967-1 C.B. 291) (lump sum payment of accumulated annual 
leave); and Rev. Rul. 66-294 (1966-2 C.B. 459) (lump sum vacation 
payment, overtime pay, lump sum retroactive pay, sick pay paid 
separately from regular pay).
    Section 31.3402(g)-1 of the regulations provides the current rules 
for withholding income tax from a payment of supplemental wages. Two 
procedures have been generally available to the employer with respect 
to such supplemental wage payments. Under the first procedure (the 
aggregate procedure), employers calculate the amount of withholding due 
by aggregating the amount of supplemental wages with the regular wages 
paid for the current payroll period or for the most recent payroll 
period this year, and treating the aggregate as if it were a single 
wage payment for the regular payroll period.

[[Page 768]]

    The second procedure for withholding on supplemental wages (the 
flat rate procedure) allows employers to disregard the amount of 
regular wages paid to an employee as well as the allowances claimed by 
an employee on Form W-4, ``Employee's Withholding Allowance 
Certificate,'' and use a flat percentage rate specified in the 
regulations in calculating the amount of withholding. This second 
procedure of withholding on supplemental wages is generally available 
only if (1) the employer has withheld income tax from regular wages 
paid the employee, and (2) the supplemental wages are either (a) not 
paid concurrently with regular wages or (b) separately stated on the 
payroll records of the employer. See Rev. Rul. 82-200 (1982-2 C.B. 
239). Under the current regulations, if the supplemental wage payment 
satisfies the conditions necessary for use of the flat rate, the 
decision whether to use the flat rate rather than the aggregate 
procedure is discretionary with the employer. Section 31.3042(g)-
1(a)(2), last modified in 1966, states that, for wages paid after April 
30, 1966, the flat percentage rate on supplemental wages is 20 percent. 
Later statutory changes have changed the applicable rate and the 
regulation is being amended to reflect those changes.
    Section 13273 of Public Law 103-66 (the Revenue Reconciliation Act 
of 1993; 107 Stat. 542) provides that the rate under section 
31.3402(g)-1 ``shall not be less than 28 percent.'' This change was 
effective for payments made after December 31, 1993., The Conference 
Report in connection with this change states that the provision 
``increases the applicable withholding rate on supplemental wage 
payments to 28 percent.'' H.R. Rep. No. 103-111, 103d Cong., 1st Sess. 
701 (1993).
    Section 101(c)(11) of Public Law 107-16 (the Economic Growth and 
Tax Relief Reconciliation Act of 2001; 115 Stat. 44) amended section 
13273 of the Revenue Reconciliation Act of 1993 by striking ``28 
percent'' and inserting ``the third lowest rate of tax applicable under 
section 1(c) of the Internal Revenue Code of 1986.'' Section 101(d)(2) 
of Public Law 107-16 provides that the change made by section 
101(c)(11) shall apply to ``amounts paid after the 60th day after the 
date of enactment of this Act.'' Public Law 107-16 was enacted into law 
on June 7, 2001. The third lowest rate of tax applicable under section 
1(c) for purposes of section 13273 of the Revenue Reconciliation Act of 
1993 was 27.5 percent. Consequently, the withholding rate for 
supplemental wages paid after August 6, 2001, and on or before December 
31, 2001, was 27.5 percent. For 2002 the third lowest rate of tax 
applicable under section 1(c) was 27 percent. As a result of the 
enactment of the Jobs and Growth Tax Relief Reconciliation Act of 2003 
(Public Law 108-27) on May 28, 2003, the third lowest rate of tax 
applicable under section 1(c) of the Internal Revenue Code (Code) for 
2003 and 2004 is 25 percent.
    Section 904(a) of Public Law 108-357, 118 Stat. 1418 (the American 
Jobs Creation Act of 2004) provides that, generally, for payments after 
December 31, 2004, the flat rate for withholding on supplemental wage 
rate ``shall not be less than 28 percent (or the corresponding rate in 
effect under section 1(i)(2) of the Internal Revenue Code of 1986 for 
taxable years beginning in the calendar year in which the payment is 
made).'' For 2005, the corresponding rate in effect under section 
1(i)(2) is 25 percent.
    Section 904(b) of the American Jobs Creation Act of 2004 also 
established a mandatory flat rate of withholding on supplemental wages 
to the extent that the employee's total supplemental wages paid by the 
employer exceed one million dollars during the calendar year. Section 
904(b) provides that ``[n]otwithstanding subsection (a), if the 
supplemental wage payment, when added to all such payments previously 
made by the employer to the employee during the calendar year, exceeds 
$1,000,000, the rate used with respect to such excess shall be equal to 
the maximum rate of tax in effect under section 1 of such Code for such 
taxable years beginning in such calendar year.'' The maximum rate of 
tax in effect under section 1 of the Code is currently 35 percent. 
Section 904(b)(2) also provides that all persons treated as a single 
employer under subsection (a) or (b) of section 52 of the Code shall be 
treated as a single employer for purposes of this provision. This new 
mandatory withholding on supplemental wages in excess of one million 
dollars is effective with respect to payments made after December 31, 
2004.
    This provision is described in the Conference Report as follows: 
``Under the Senate amendment, once annual supplemental wage payments to 
an employee exceed $1 million, any additional supplemental wage 
payments to the employee in that year are subject to withholding at the 
highest income tax rate (35 percent for 2004 and 2005), regardless of 
any other withholding rules and regardless of the employee's Form W-
4.'' H.R. Rep. No. 108-475 at 785-6 (2004).
    This provision for withholding on supplemental wages in excess of 
one million dollars was originally included as part of S. 2424, 108th 
Cong., 2d Sess. (2004). The legislative history in connection with S. 
2424 provided as follows with respect to the reasons for change: ``The 
Committee believes that because most employees who receive annual 
supplemental wage payments in excess of $1 million will ultimately be 
taxed at the highest rate, it is appropriate to raise the withholding 
rate on such payments so that withholding more closely approximates the 
ultimate tax liability with respect to these payments.'' S. Rep. No. 
108-266 at 105 (2004).
    In a conforming amendment, the 2004 Act repealed section 13273 of 
the Revenue Reconciliation Act of 1993.

Explanation of Provisions

    The proposed regulations change the optional flat rate of 
withholding on supplemental wages to provide that the 20 percent rate 
applies only to supplemental wages paid prior to January 1, 1994. The 
rate of 28 percent applies to supplemental wages paid after December 
31, 1993, and on or before August 6, 2001. The Revenue Reconciliation 
Act of 1993, as amended by the Economic Growth and Tax Relief 
Reconciliation Act of 2003, provides that the supplemental withholding 
rate shall not be less than the third lowest rate of tax applicable 
under section 1(c) for wages paid after August 6, 2001, and before 
January 1, 2005. Consistent with this amendment, the regulations 
provide that the rate of 27.5 percent applies to supplemental wages 
paid after August 6, 2001, and on or before December 31, 2001, the rate 
of 27 percent applies to wages paid after December 31, 2001, and on or 
before May 27, 2003, and the rate of 25 percent applies to wages paid 
after May 27, 2003, and on or before, December 31, 2004. Although the 
Jobs and Growth Tax Relief Reconciliation Act of 2003 provided that the 
third lowest rate of tax under section 1(c) after December 31, 2002, 
would be 25 percent, this provision was not enacted into law until May 
28, 2003. Thus, at the time of payments of supplemental wages made 
after December 31, 2002, and prior to May 28, 2003, the third lowest 
rate of tax under section 1(c) was 27 percent. This provision is 
consistent with the general principle that the employment taxation of 
wage payments is determined based on the rates in effect at the date 
the wages are paid. United States v. Cleveland Indians Baseball Co., 
532 U.S. 200 (2001).
    To track the statutory language of the American Jobs Creation Act 
of 2004, the regulation provides that, for wages paid after December 
31, 2004, the flat rate for

[[Page 769]]

supplemental wages is generally 28 percent (or the corresponding rate 
in effect under section 1(i)(2) * * * for taxable years beginning in 
the calendar year in which the payment is made). Under current law, the 
corresponding rate in effect under section 1(i)(2) for taxable years 
beginning in 2005 is 25 percent. Thus, for 2005, the optional flat rate 
for supplemental wages under $1 million in a given taxable year is 25 
percent. The optional flat rate will remain at 25 percent until income 
tax rates change.\1\ However, as described below, a higher mandatory 
rate applies for withholding on supplemental wages in excess of one 
million dollars.
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    \1\ Under current law, section 1(i)(2) will not be applicable to 
taxable years beginning after December 31, 2010, pursuant to the 
sunset provisions contained in section 901 of the Economic Growth 
and Tax Relief Reconciliation Act of 2001 (Public Law 107-16; 115 
Stat. 150). See also section 107 of Public Law 108-27 (117 Stat. 
755). Absent legislative action, the optional flat rate will change 
to 28 percent in 2011.
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    The regulation provides that if a supplemental wage payment, 
together with all other supplemental wage payments paid by an employer 
to an employee during the calendar year, exceeds one million dollars, 
the withholding rate on the supplemental wages in excess of one million 
dollars shall be equal to the maximum rate of tax in effect under 
section 1 for taxable years beginning in such calendar year. Under 
current law, the maximum rate of tax in effect for taxable years 
beginning in 2005 is 35 percent. Thus, in 2005, the mandatory flat rate 
for supplemental wages in excess of $1 million in a given taxable year 
is 35 percent. The mandatory rate will remain at 35 percent until 
income tax rates change.\2\
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    \2\ Under the sunset provision in section 901 of the Economic 
Growth and Tax Relief Reconciliation Act of 2001, the mandatory flat 
rate will change to 39.6 percent for taxable years beginning after 
December 31, 2010.
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    These proposed regulations also clarify which wages are classified 
as supplemental wages. Under the proposed regulations, supplemental 
wages include any payment of wages by an employer that is not regular 
wages. Regular wages are defined as amounts paid by an employer for a 
payroll period either at a regular hourly rate or in a predetermined 
fixed amount. Wages that vary from payroll period to payroll period 
based on factors other than the amount of time worked, such as 
commissions, tips, and bonuses, are supplemental wages if they are paid 
in addition to regular wages. See Rev. Rul. 82-46 (1982-1 C.B. 158). 
However, if an employee receive only one type of compensation from an 
employer, that type of compensation will be regular wages even if the 
type of compensation is something that would normally be classified as 
supplemental wages. For example, if an employee receives only stock 
options as compensation from the employer and receives no other wages 
(including no includible fringe benefits that are wages), then the 
income on the exercise of the options would generally be regular wages, 
rather than supplemental wages.
    The definitions of supplemental wages and regular wages were 
developed based on the historical usage of the term in regulations and 
revenue rulings. Examples are included in the regulations to illustrate 
the application of the definitions to specific scenarios. The IRS 
welcomes comments on whether this definition of supplemental wages is 
appropriate.
    When determining whether payments are regular wages or supplemental 
wages, and furthermore, whether the supplemental wages paid by an 
employer to an employee in a given taxable year exceed $1 million, an 
employer (the first employer) must consider wage payments made to the 
employee by any other person treated as a single employer with the 
first employer under section 52(a) or 52(b). Furthermore, if an 
employer enlists a third party to make a payment to an employee on the 
employer's behalf, the payment will be considered as made by the 
employer even though it may have been delivered to the employee by the 
third party.
    The new mandatory withholding rate on supplemental wages can apply 
to a full payment or only a portion of a payment. The maximum rate 
withholding applies only to the excess of supplemental wages over one 
million dollars received by an employee from an employer, taking into 
consideration all payments of supplemental wages made by an employer to 
an employee. All payments of supplemental wages are considered in 
determining this threshold regardless of whether the payments were 
subjected to flat rate withholding. The amount of regular wages paid to 
the employee has no relevance in determining whether the new mandatory 
withholding rate applies. Also, if a payment to an employee from an 
employer is not ``wages'' as defined under section 3401(a), such 
payment has no effect on whether the million dollar threshold for 
mandatory flat rate withholding has been reached.
    If a particular supplemental wage payment results in an employee 
exceeding the million dollar supplemental wage threshold, mandatory 
flat rate withholding will apply to the extent that the payment 
together with other supplemental wage payments made to the employee 
previously during the year is an excess of one million dollars. 
However, to the extent that such a supplemental wage payment does not 
exceed one million dollars when combined with the other previous 
supplemental wage payments, the mandatory flat rate does not apply, and 
withholding may be calculated on that portion of the payment under the 
rules generally applicable to other supplemental wage payments.
    Withholding on regular wages of the employee will continue to be 
calculated under the method used by the employer with respect to 
regular wages after the employee has reached the million dollar 
supplemental wage threshold.
    The regulations also clarify that the mandatory flat rate applies 
regardless of the withholding method used by the employer with respect 
to regular wages. The regulations also clarify that mandatory flat rate 
withholding applies even if the employee receiving the supplemental 
wages in excess of $1 million has a Form W-4 asserting exempt status 
pursuant to section 3402(n). Moreover, the regulations also clarify 
that mandatory flat rate withholding applies to noncash remuneration 
paid to a retail commission salesperson (section 3402(j)) to the extent 
that such remuneration constitutes supplemental wages and exceeds $1 
million in a given taxable year.
    Examples of how the withholding would be calculated under the 
mandatory flat rate are included in the regulation. Among other things, 
the examples illustrate that because the higher rate is mandatory, 
where an employer provides net bonuses (i.e., after withholding) at a 
specified level, the total of the amount of such net bonuses and the 
gross up for withholding that are in excess of $1 million of 
supplemental wages will be subject to the higher rate.
    The proposed regulations also clarify that, generally, where an 
employer has paid an employee supplemental wages that are cumulatively 
one million dollars or less for a given taxable year, the flat rate of 
withholding on supplemental wages can be used only if (1) income tax 
has been withheld from the employee's regular wages and (2) the 
supplemental wages are either not paid concurrently with regular wages 
of the employer if paid concurrently with regular wages, are separately 
stated on the payroll records of the employer.
    The proposed regulations do not change the Federal Insurance

[[Page 770]]

Contributions Act (FICA) taxation of wages.

Proposed Effective Date

    This regulation will be effective on the date published as a final 
regulation in the Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations, and because the 
regulation does not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Code, this notice of proposed 
rulemaking will be submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.

Comments and Requests for Public Hearing

    Before these proposed regulation are adopted as final regulations, 
consideration will be given to any written (a signed original and 8 
copies) or electronic comments that are submitted timely to the IRS. 
The IRS and Treasury Department request comments on the clarity of the 
proposed rules and how they can be made easier to understand. All 
comments will be available for public inspection and copying. A public 
hearing may be scheduled if requested in writing by any person that 
timely submits written comments. If a public hearing is scheduled, 
notice of the date, time, and place for the public hearing will be 
published in the Federal Register.

Drafting Information

    The principal author of these regulations is A. G. Kelley, Office 
of Division Counsel/Associate Chief Counsel (Tax Exempt and Government 
Entities). However, other personnel from the IRS and Treasury 
participated in their development.

List of Subjects in 26 CFR Part 31

    Employment taxes, Income taxes.

Proposed Amendment to the Regulations

    Accordingly, 26 CFR is proposed to be amended as follows:

PART 31--EMPLOYMENT TAXES AND COLLECTION OF INCOME TAX AT SOURCE

    Paragraph 1. The authority citation to part 31 is amended by adding 
an entry in numerical order to read, as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 31.3402(n)-1 also issued under 26 U.S.C. 6011 and 6364. * * 
*

    Par. 2. Section 31.3401(a)-1 is amended by revising paragraph 
(b)(8)(i)(b)(2) as follows:


Sec.  31.3401(a)-1  Wages.

* * * * *
    (b) * * *
    (8) * * *
    (i) * * *
    (b) * * *
    (2) Payments made by agents subject to this paragraph are 
supplemental wages as defined in Sec.  31.3402(g)-1, and are therefore 
subject to the rules regarding withholding tax on supplemental wages 
provided in Sec.  31.3402(g)-1. For purposes of those rules, unless the 
agent is also an agent for purposes of withholding tax from the 
employees' regular wages, the agent may deem tax to have been withheld 
form regular wages paid to the employee during the calendar year.
* * * * *
    Par. 3 Section 31.3401(a)-4 is amended by revising paragraph (c) to 
read as follows


Sec.  31.3401(a)-4  Reimbursements and other expense allowance amounts.

* * * * *
    (c) Withholding rate. Payments made under reimbursement or other 
expense allowance arrangements that are subject to income tax 
withholding are supplemental wages under Sec.  31.3402(g)-1 if paid in 
addition to regular wages. Accordingly, withholding on such 
supplemental wages is calculated under the rules provided with respect 
to supplemental wages in Sec.  31.3402(g)-1.
* * * * *
    Par. 4. Section 31.3402(g)-1 is amended by:
    (1) Revising paragraph (a).
    (2) Adding a sentence at the beginning of paragraph (b)(1).
    (3) Revising paragraph (b)(2).
    The revisions and addition read as follows:


Sec.  31.3402(g)-1  Supplemental wage payments.

    (a) In general and withholding applicable with respect to 
supplemental wages in excess of $1,000,000. (1)(i) An employee's 
remuneration may consist of regular wages and supplemental wages. 
Supplemental wages are all wages paid by an employer that are not 
regular wages. Supplemental wages include wage payment made without 
regard to an employee's payroll period, but also may include payments 
made for a payroll period. Examples of wage payments that are included 
in supplemental wages, if paid in addition to regular wages, include 
bonuses, overtime pay, back pay, reported tips, commissions, wages paid 
under reimbursement or other expense allowance, wages paid as noncash 
fringe benefits, sick pay paid by a third party as an agent of the 
employer, amounts that are includible in gross income under section 
409A, and income recognized on the exercise of a nonqualified stock 
option.
    (ii) As distinguished form supplemental wages, regular wages are 
amounts that are paid at a regular hourly, daily, or similar periodic 
rate (and not an overtime rate) for the current payroll period or at a 
predetermined fixed determinable amount for the current payroll period. 
Thus, among other things, wages that vary from payroll period to 
payroll period (such as commissions, tips, or bonuses) are not regular 
wages if paid in addition to regular wages. Any overtime pay paid in 
addition to regular wages would not be included in regular wages. 
However, if the only wages that an employee receives during a calendar 
year are bonuses, commissions, tips, or another type of payments that 
would normally be classified as supplemental wages if paid in addition 
to regular wages, then such wages are treated as regular wages. For 
example, if the only wages an employee receives are commissions paid on 
a monthly basis, then the payment of the commissions by the employer 
would be regular wages paid for a monthly payroll period.
    (iii) The calculation of the amount of the income tax withholding 
with respect to supplemental wage payments is provided for under 
paragraph (a)(2) through (a)(7) of this section.
    (2) If a supplemental wage payment, when added to all supplemental 
wage payments previously made by one employer (as defined in paragraph 
(a)(3) of this section) to an employee during the calendar year, 
exceeds $1,000,000, the rate used in determining the amount of 
withholding on the excess (including any excess which is apportion of a 
supplemental wage payment) shall be equal to the highest rate of tax 
applicable under section 1 for such taxable years beginning in such 
calendar year. This flat rate shall be applied without regard to 
whether income tax has been withheld from the employee's regular wages, 
without allowance for the

[[Page 771]]

number of withholding allowances claimed by the employee on Form W-4, 
``Employee's Withholding Allowance Certificate'', without regard to 
whether the employee has claimed exempt status on Form W-4, and without 
regard to the withholding method used by the employer.
    (3) For purposes of paragraph (a)(2) of this section, including for 
purposes of determining whether any given payment is a payment of 
supplemental wages subject to paragraph (a)(2) of the section--
    (i) All persons treated as a single employer under subsection (a) 
to (b) of section 52 shall be treated as one employer; and
    (ii) Any payment made to an employee by a third party acting as an 
agent for the employer (regardless of whether such person shall have 
been designated as an agent pursuant to section 3504) shall be 
considered as made by the employer.
    (4) To the extent that paragraph (a)(2) of this section does not 
apply to a supplemental wage payment (or a portion of a payment), the 
amount of the tax required to be withheld on the supplemental wages 
when they are paid shall be determined under the rules provided in 
paragraphs (a)(5) and (6) of this section.
    (5)(i) The employer is required to determine withholding upon 
supplemental wages under this paragraph (a)(5) if paragraph (a)(2) of 
this section does not apply to the payment or portion of the payment 
and if paragraph (a)(6) of this section may not be used with respect to 
the payment. In addition, employers have the option of using this 
paragraph (a)(5) to calculate withholding with respect to a 
supplemental wage payment, if paragraph (a)(2) of this section does not 
apply to the payment, built if paragraph (a)(6) of this section could 
be used with respect to the payment.
    (ii) Provided this procedure applies under paragraph (a)(5)(i) of 
this section, the supplemental wages, if paid concurrently with wages 
for payroll period, are aggregated with the wages paid for such payroll 
period. If not paid concurrently, the supplemental wages are aggregated 
with the wages paid or to be paid within the same calendar year for the 
last preceding payroll period or for the current payroll period. The 
amount of tax to be withheld is determined as if the aggregate of the 
supplemental wages and the regular wages constituted a single wage 
payment for the regular payroll period.
    (6)(i) The employer may determine withholding upon supplemental 
wages under this paragraph (a)(6) if three conditions are met--
    (A) Paragraph (a)(2) of this section does not apply to the payment 
or the portion of the payment;
    (B) The supplemental wages are either not paid concurrently with 
regular wages or are separately stated on the payroll records of the 
employer; and
    (C) Income tax has been withheld from the employee's regular wages.
    (ii) The determination of the tax to be withheld under paragraph 
(a)(6)(iii) of this section is made without allowance for exemption and 
without reference to any payment of regular wages.
    (iii) Provided the conditions of paragraph (a)(6)(i) of this 
section have been met, the employer may determine the tax to be 
withheld--
    (A) From supplemental wages paid after April 30, 1966, and prior to 
January 1, 1994, by using a flat percentage rate of 20 percent;
    (B) From supplemental wages paid after December 31, 1993, and on or 
before August 6, 2001, by using a flat percentage rate of 28 percent;
    (C) From supplemental wages paid after August 6, 2001, and on or 
before December 31, 2001, by using a flat percentage rate of 27.5 
percent;
    (D) From supplemental wages paid after December 31, 2001, and on or 
before May 27, 2003, by using a flat percentage rate of 27 percent;
    (E) From supplemental wages paid after May 27, 2003, and on or 
before December 31, 2004, by using a flat percentage rate of 25 
percent; and
    (F) From supplemental wages paid after December 31, 2004, by using 
a flat percentage rate of 28 percent (or the corresponding rate in 
effect under section 1(i)(2) for taxable years beginning in the 
calendar year in which the payment is made).
    (7) The following examples illustrate this paragraph (a):

    Example 1. (i) A is an employee of three entities (X, Y, and Z) 
that are treated as a single employer under section 52(a) or (b). In 
year 20XX, A receives regular wages on a monthly payroll periods 
paid by X for services performed for X, Y, and Z on the third 
business day of each month. The maximum rate of income tax under 
section 1 in effect for year 20XX is 35 percent, and the 
corresponding rate to 28 percent in effect under section 1(i)(2) for 
taxable years beginning in 20XX is 25 percent. Income tax is 
withheld from the regular wages of A during the year. A receives 
only the following supplemental wage payments during 20XX in 
addition to the regular wages paid by X--
    (a) a bonus of $600,000 from X on March 15, 20XX;
    (b) a bonus of $2,300,000 from Y on November 15, 20XX; and
    (c) a bonus of $10,000 from Z on December 31, 20XX.
    (ii) In this Example 1, the withholding on the $600,000 payment 
from X could be determined under either paragraph (a)(5) or (6) of 
this section because income tax has been withheld from the regular 
wages of A. If X elects to use the aggregate procedure under 
paragraph (a)(5) of this section, the amount of withholding on the 
supplemental wages would be based on aggregating the supplemental 
wages and the regular wages paid by X either for the current or last 
payroll period and treating the total of the regular wages paid by X 
and the $600,000 supplemental wages as a single payment for a 
regular payroll period. The withholding method used by the employer 
with respect to regular wages would then be used to calculate the 
withholding on this single wage payment, and the employer would take 
into consideration the Form W-4 filed by the employee.
    (iii) In this Example 1, because the $2,300,000 bonus from Y, 
together with the regular wages paid by X, is treated as made from 
one employer, the payment is a supplemental wage payment. To 
calculate the withholding on the $2,300,000 supplemental wage 
payment from Y, it would be necessary to take into account that A 
has already received $600,000 of supplemental wages from X, which is 
treated as the same employer as Y under section 52(a) or (b). Thus, 
the withholding on the amount of the payment not in excess of 
$1,000,000 cumulative supplemental wages would need to be computed 
separately from the amount of the payment above $1,000,000. With 
respect to the first component of this supplemental wage payment, 
equal to $400,000, the withholding could be computed under either 
paragraph (a)(5) or (a)(6) of this section, because income tax has 
been withheld from the regular wages of the employee. If Y elected 
to withhold income tax using paragraph (a)(6) of this section, Y 
would withhold on the $400,000 component at 25 percent (pursuant to 
paragraph (a)(6)(ii)(F) of this section), which would result in 
$100,000 tax withheld. The second component of $1,900,000 would be 
subject to mandatory income tax withholding at the maximum rate of 
tax in effect under section 1 for 20XX. The income tax required to 
be withheld on the second component of this supplemental wage 
payment would be calculated without regard to the Form W-4 filed by 
A and would be 35 percent of $1,900,000 or $665,000. The withholding 
on the first component and the withholding on the second component 
then would be added together to determine the total income tax 
withholding on the supplemental wage payment from Y, or $100,000 
plus $665,000 ($765,000).
    (iv) The bonus paid from Z is also a supplemental wage payment, 
because Z, together with X, is treated as a single employer. The 
calculation of the withholding on the supplemental wage payment from 
Z to A of $10,000 would also be required to take into account that A 
has received prior supplemental wage payments during the year in 
excess of one million dollars from X and Y, because Z is treated as 
the same employer

[[Page 772]]

as X and Y. The income tax required to be withheld on this payment 
would be 35 percent of $10,000 or $3,500.
    Example 2. Employees B and C work for employer M. Each employee 
receives monthly salaries of $3,000 which are paid on the fifth 
business day after the end of the month. As a result of the 
withholding allowances claimed by B, there is no income tax 
withholding on the regular wages of B paid by M. In contrast, M has 
withheld income tax from C's regular wages paid by M. Together with 
the monthly salary check paid on the fifth business day of December, 
M includes a bonus of $2,000, which is the only supplemental wage 
payment received by each employee for the calendar year. The bonuses 
are separately stated on the payroll records of M. M must calculate 
the income tax withholding required to be made with respect to the 
bonus paid to B by using the procedure set forth in paragraph (a)(5) 
of this section. With respect to the bonus paid to C, M has the 
option of using either the aggregate method provided under paragraph 
(a)(5) of this section or the optional flat rate provided under 
paragraph (a)(6) of this section to calculate the income tax 
withholding due.
    Example 3. (i) Employee D works as an employee of Corporation R. 
Corporations R, S, and T are treated as a single employer under 
subsection (a) or (b) of section 52. Employee D receives regular 
wage payments of $200,000 on a monthly basis in 2005 from R and 
income tax is withheld from those wages. D receives a bonus for his 
services as an employee from R equal to $3,000,000 on June 30, 2005. 
Unrelated company U pays D sick pay as an agent of the employer R 
and such sick pay is supplemental wages pursuant to Sec.  
31.3401(a)-1(b)(2). D receives sick pay of $50,000 on October 31, 
2005. Corporation T decides to award bonuses to all employees of R, 
S, and T, and pays a bonus of $100,000 to D on December 31, 2005. D 
received no other payments from U, P, or T.
    (ii) In chronological summary, D receives the following wages 
other than the regular monthly wages paid by R:
June 30, 2005--$3,000,000 (bonus from R)
October 31, 2005--$50,000 (sick pay from U)
December 31, 2005--$100,000 (bonus from T)
    (iii) In this Example 3, each payment of wages other than the 
regular monthly wage payments from R is considered to be 
supplemental wages for purposes of withholding under Sec.  
31.3402(g)-1(a)(2) because, pursuant to Sec.  31.3402(g)-1(a)(3), 
the payments are treated as made by one employer. The amount of 
regular wages from R is irrelevant in determining when maximum rate 
withholding on supplemental wages applies.
    (iv) Because income tax has been withheld on the regular wages 
of the employee, income tax may be withheld on $1,000,000 of the 
$3,000,000 bonus paid on June 30, 2005, under either paragraph 
(a)(5) or (6) of this section. If R elects to withhold income tax at 
the flat rate provided under paragraph (a)(6)(ii)(F), withholding 
would be calculated at 25 percent of the $1,000,000 portion of the 
payment, or $250,000.
    (v) Income tax withheld on the following supplemental wage 
payments (or portion of a payment) as follows is required to be 
calculated at the maximum rate in effect under section 1(c), or 35 
percent in 2005--
    (A) $2,000,000 of the $3,000,000 bonus paid by R on June 30, 
2005;
    (B) $50,000, the sick pay paid on October 31, 2005; and
    (C) $100,000, the bonus paid by T on December 31, 2005.
    Example 4. (i) Employer J has decided it wants to grant its 
employee B a $1,000,000 net bonus (after withholding). Employer J 
has withheld income tax from the regular wages of the employee. B 
has received no other supplemental wage payments during the year. 
The mandatory flat rate in effect in the year in which the payment 
is made is 35 percent, and the optional flat rate in effect is 25 
percent.
    (ii) This Example 4 requires grossing up the wage payment to 
determine the gross wages necessary to result in a net payment of 
$1,000,000. If the employer elected to use the flat rate applicable 
to supplemental wages, the first $1,000,000 of the wages would be 
subject to 25 percent withholding. However, any wages above that 
would be subject to mandatory 35 percent withholding. The 
withholding applicable to the first $1,000,000 (i.e., $250,000) 
would thus be required to be grossed-up at a 35 percent rate to 
determine the gross wage amount above $1,000,000. Thus, the wages 
above $1,000,000 would be equal to $250,000 divided by .65 (computed 
by subtracting .35 from 1) or $384,615.38. Thus the total 
withholding with respect to the payment if Employer J elected the 
flat rate with respect to the first $1,000,000, would be $384,615.38 
and the total supplemental wage payment, taking into account income 
tax withholding only (and not Federal Insurance Contributions Act 
taxes), to B would be $1,384,615.38.

    (8) For provisions relating to the treatment of wages that are not 
subject to paragraph (a)(2) of this section and that are paid other 
than in cash to retail commission salesmen, see Sec.  31,3402(j)-1.
    (b) Special rule where aggregate withholding exemption exceeds 
wages paid. (1) This rule applies only if paragraph (a)(2) of this 
section does not apply to the supplemental wage payment. * * *
    (2) The rules prescribed in this paragraph shall, at the election 
of the employer, be applied in lieu of the rules prescribed in 
paragraph (a) of this section except that this paragraph shall not be 
applicable in any case in which the payroll period of the employee is 
less than one week or if paragraph (a)(2) applies to the supplemental 
wage payment.
* * * * *
    Par. 5. Section 31.3402(j)-1 is amended by adding a new sentence at 
the beginning of paragraph (a)(2) to read as follows:


Sec.  31.3402(j)-1  Remuneration other than in cash for service 
performed by retail commission salesman.

    (a) * * *
    (2) Section 3402(j) and this section are not applicable with 
respect to wages paid to the employee that are subject to withholding 
under section 31.3402(g)-1(a)(2). * * *
* * * * *
    Par. 6. Section 31.3402(n)-1 is revised and the authority citation 
at the end of the section is removed to read as follows:


Sec.  31.3402(n)-1  Employees incurring no income tax liability.

    (a) Notwithstanding any other provision of this subpart (except to 
the extent a payment of wages is subject to withholding under Sec.  
31.3402(g)-1(a)(2)), an employer shall not deduct and withhold any tax 
under chapter 24 upon a payment of wages made to an employee after 
April 30, 1970, if there is in effect with respect to the payment a 
withholding exemption certificate furnished to the employer by the 
employee which contains statements that--
    (1) The employee incurred no liability for income tax imposed under 
subtitle A of the Internal Revenue Code for his preceding taxable year; 
and
    (2) The employee anticipates that he will incur no liability for 
income tax imposed under subtitle A for his current taxable year.
    (b) To the extent wages are subject to withholding under Sec.  
31.3402(g)-1(a)(2), such wages are subject to such income tax 
withholding regardless of whether a withholding exemption certificate 
under section 3402(n) and the regulations thereunder has been furnished 
to the employer.
    (c) For purposes of section 3402(n) and this section, an employee 
is not considered to incur liability for income tax imposed under 
subtitle A if the amount of such tax is equal to or less than the total 
amount of credits against such tax which are allowable to him under 
part iv of subchapter A of chapter 1 of the Internal Revenue Code, 
other than those allowable under section 31 or 39. For purposes of 
seciton 3402(n) and this section, ``liability for income tax imposed 
under subtitle A'' shall include

[[Page 773]]

liability for a qualified State individual income tax which is treated 
pursuant to section 6361(a) as if it were imposed by chapter 1 of the 
Internal Revenue Code. An employee is not considered to incur liability 
for such a State income tax if the amount of such tax does not exceed 
the total amount of the credit against such tax which is allowable to 
him under section 6362(b)(2)(B) or (C) or section 6362(c)(4). For 
purposes of this section, an employee who files a joint return under 
section 6013 is considered to incur liability for any tax shown on such 
return. An employee who is entitled to file a joint return under such 
section shall not certify that he anticipates that he will incur no 
liability for income tax imposed by subtitle A for his current taxable 
year if such statement would not be true in the event that he files a 
joint return for such year, unless he filed a separate return for his 
preceding taxable year and anticipates that he will file a separate 
return for his current taxable year.
    (d) For rules relating to invalid withholding exemption 
certificates, see Sec.  31.3402(f)(2)-1(e), and for rules relating to 
submission to the Internal Revenue Service of withholding exemption 
certificates claiming a complete exemption from withholding, see Sec.  
31.3402(f)(2)-1(g).

    (e) Example 1. Employee A, an unmarried, calendar-year basis 
taxpayer, files his income tax return for 1970 on April 15, 1971. A 
has adjusted gross income of $1,200 and is not liable for any tax. 
He had $180 of income tax withheld during 1970. A anticipates that 
his gross income for 1971 will be approximately the same amount, and 
that he will not incur income tax liability for that year. On April 
20, 1971, A commences employment and furnishes his employer an 
exemption certificate stating that he incurred no liability for 
income tax imposed under subtitle A for 1970, and that he 
anticipates that he will incur no liability for income tax imposed 
under subtitle A for 1971. A's employer shall not deduct and 
withhold on payments of wages made to A on or after April 20, 1971. 
Under Sec.  31.3402(f)(4)-1(c), unless A files a new exemption 
certificate with his employer, his employer is required to deduct 
and withhold upon payments of wages to A made on or after May 1, 
1972. Under Sec.  31.3402(f)(3)-1(b), if A had been employed by his 
employer prior to April 20, 1971, and had furnished his employer a 
withholding exemption certificate not containing the statements 
described in Sec.  31.3402(n)-1 proir to furnishing the withholding 
exemption certificate containing such statements on April 20, 1971, 
his employer would not be required to give effect to the new 
certificate with respect to payments of wages made by him prior to 
July 1, 1971 (the first status determiantion date which occurs at 
least 30 days after April 20, 1971). However his employer could, if 
he chose, make the new certificate effective with respect to any 
payment of wages made on or after April 20 and before July 1, 1971.
    Example 2. Assume the facts are the same as in Example 1 except 
that for 1970 A has taxable income of $8,000, income tax liability 
of $1,630, and income tax withheld of $1,700. Although A received a 
refund of $70 due to income tax withholding of $1,700, he may not 
state on his exemption certificate that he incurred no liability for 
income tax imposed by subtitle A for 1970.

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 05-71 Filed 1-4-05; 8:45 am]
BILLING CODE 4830-01-P